In December last year, the Californian Public Employees’ Retirement System (Calpers), the largest pension fund in the US, agreed to publish the management fees and performance figures for its private equity and hedge fund investments, following a lawsuit brought on by a pressure group.
Concerned about revealing information that would impact performance; the fund developed customised spreadsheets with bottom line information. Mark Anson, chief investment officer, says: “As an investor in the private equity and hedge fund market, Calpers negotiates fees, carried interest, and profit splits with partnerships. If all the terms and conditions were disclosed, Calpers would likely be shut out of top-tier investment funds and would be put in an unfavourable position when negotiating terms of a deal.”
The lawsuit demonstrated two things. The first, that investors are demanding more information and greater transparency. The second, that private equity managers still call most of the shots in the industry. And no where is this demonstrated better than with the issue of fees.
“We don’t have much negotiating power. If you want to go into the best managers, there’s little basis for negotiation of fees,” says a private equity manager at one of the UK’s billion plus pension funds, declining to comment on the record. And nobody could blame him.
Thomas Kubr, chief executive of Capital Dynamics, the private equity firm which acquired Westport Private Equity from the Man Group in February, explains: “There’s a general sense that a lot of money is going into the industry, on the other hand, people don’t want to be too critical because they don’t want to be boxed out of a good fund.”
In 2003, the University of Carolina Retirement System saw its money returned to it by two private equity managers, Sequoia Capital and Three Arch Partners, after a judge ruled that the firm would have to disclose the details of its venture capital operations. The pension scheme was barred from further investment in the funds. Although the issue was disclosure of sensitive information rather than the fees themselves, the university had little control over what happened to its assets.
It doesn’t help that the market has recovered, giving limited partnerships (LPs) less room for protest. Private equity returned 18.8% in the year to the second half of 2004, according to Thompson Venture Economics and the National Venture Capital Association. The recovery followed a succession of losses.
“I think two or three years ago, when times were tough for the industry, there was a potential opportunities for LPs to gang together and say ‘if you want our money we want to see transaction and or management fees coming down.’ But LPs didn’t really do it, they missed the boat. The power has now swung back, certainly to the well established GPs,” says John Edwards, a consultant with MM&K, the London-based compensation consultancy.

A 2004 survey of pay and incentive practices in the European private equity industry by MM&K revealed that of the 67 funds covered, the average management fee was 1.96%, and the median was 2% (the same level since 2000). The results also indicated that of the 50 funds which charge transaction fees, 24 split their transaction fees between the investor and the manager (usually on a 50:50 basis), while a further 10 funds now distribute all transaction and arrangement fees to investors. The remaining 16 pay all the transaction fees to the manager.
“The area where there is more need for transparency is in the inclusion of transaction fees in the management arrangement fees,” argues Alan Briefel, managing director of StratCom, the consultancy group. And many investors agree that they should only have to deal with one integrated fee.
Most managers and more reluctantly, institutional investors, accept that a 2% management fee and 20% carry, a performance bonus payable after a certain hurdle rate which is typically only paid back after LPs receive their original investment back, is now industry standard. But observers stress that the devil is in the details, and that LPs need to carefully monitor other fees. GPs charge a great deal of fees to the companies they invest in, not only transaction fees, but monitoring fees, and directors’ fees. There is no set standard.
“Often you don’t realise until you see the legal agreements of what is being included and what isn’t,” explains Sanjay Mistry, a consultant with Mercer Investment Consulting. He encourages LPs to pay attention to everything, down to what they are being charged for marketing. “You talk about standard management charges but there are other expenses and you need to be more careful,” he says.
For his part, Briefel cites the example of a large, US private equity fund, that was allocating carry globally, and not to the local teams achieving the deal, so that the success of the fund’s European team was sucked into the main business. “Investors are looking much harder at the carry and how the fees translate into rewards,” he says.
But managers are tired of being attacked on all sides. “We have a philosophy of complete openness with our clients,” explains Andrew Hartley, joint managing director of Klienwort Capital, which spun out of Dresdner Bank in 2001. He says that his books are open to LPs, and he is prepared to account for how management fees are spent. But he also wants investors to be aware the running a private equity business has become more expensive. “There’s more corporate governance and regulation. There is much more demand to provide information to investors, which is fine but takes time. We also put in more time into reviewing investments and making investment decisions,” he says.
Bill Watson, partner at Baring Private Equity Partners in London, agrees. As a specialist player, the firm needs to have local presence in all its markets. “So LPs have to buy into the proposition that the costs of the business model will result in superior returns in the aggregate.”
Watson also points out that transparency has dramatically increased compared to five years ago, and that progress has been made. Others point out that managers have to be continuously hands on, whether it’s sitting on the board of their portfolio management companies, to shaping strategies and recruiting talent. It is time consuming, and can take up to six months for investment. They argue that comparing private equity to other asset classes is unhelpful, and defeats the purpose.

The one thing investors and managers do agree on however, is that standardisation would be a good step forward. “I think what we can expect is more standardisation of the fees issue, especially on secondary issues such as catch up, claw back, and the offset of transaction fees against management fees. The two and twenty structure is fairly well established,” says Kubr.
But Bruno Raschle, chief executive of Zurich-based Adveq, puts it in simpler terms. “Greed is the driver for taking a certain position, or demonstrating inflexibility. As soon as you put the fee issue into the context of fiduciary governance, I would say we have a much easier conversation or debate. The discussion would then circle around topics like taking and managing investment risk, or structural and performance risk.”
LPs say it is not always a matter of choice. Those funds that have a track record, and are strong performers, will constantly be in demand. Others, which are either newly launched or have no track record, will find it harder to charge significant fees. But, MM&K’s Edwards points out, nobody wants to admit to being bottom quartile, and for investors, the tried and tested manager has traditionally been a safe bet. And, says StratCom’s Briefel: “Pension funds are increasingly competing to get onto capacity constrained funds. The question going forward is, who is going to call the shots in a capacity constrained environment?”
You won’t see many LPs raising their hands.